I've been struggling with something for a few weeks now that was exacerbated by last weekend's BCS selection of the #2 and #3 teams playing for the national title over #1. Why do people and institutions completely ignore common sense? This is the same question I have thinking about with the current mutual fund scandal (Heartland Advisors is the most recent one).
The only answer I can come up with is that people -- acting as individuals and executives in institutions -- misprice the cost of risk to their reputations. Or maybe more accurately, they price that risk at zero. Consequently, they don't factor in how harm to their reputation will hurt their ability to achieve their goals, or even survive, in the future.
Example 1 - Mutual Fund Scandal
In the case of the mutual fund scandal, fund executives allowed favorable customers to market time trades in their funds to the detriment of other shareholders. And while market timing is not illegal in most situations, when you have in your marketing materials and regulatory filings that you will not allow such actions because they hurt other shareholders, it becomes illegal. So these funds and executives who profitted in the hundreds of thousands of dollars risked hundreds of millions - or billions in the case of Putnam. And in the end, the risk to institutional and personal reputations prevailed. The reputational risk has been extraordinary. Putnam has lost more than $15 billion in assets under managment and the CEO lost his job (rightly so!). And maybe the most egregious examples is Dick Strong of Strong Funds -- a man who lost hundreds of millions of dollars of value in his firm for the great opportunity to earn seven hundred thousand for friends and family.
Example 2 - Bowl Championship Series
Help me understand this. How is an institution whose sole purpose is to get a unified national champion not have the consensus #1 team in the country according to the historically two dominant not playing for the title? Yet the #3 team in both those polls is playing despite not even winning its conference championship. Now the BCS uses five or six other obscure polls and incorporates a quantitative measure to come up with its strength of schedule. And this is probably the right process when there is some confusion over who is the #1 team in the country. So the BCS, rather than come out and declare that a change to the system should be made this year by doing the common sensical thing of having #1 in the polls play the consensus #2, chooses to go ahead with the game. Maybe in the short term, i.e. 1 year, this will keep the BCS relevant. But in the longer term, the BCS has rung its own death knell. The risk to the BCS's long-term reputation is far greater from not coming out and saying that in this year, they should make a change, than to own up to the inadequancy in real time.
The mutual fund scandal and BCS selection process both show how institutions and executives do not think about their reputational risk from certain actions. As a result, they focus far too much on the short-term and as a result, leave an indellible mark on their futures. In essence, they fail to "do right." This lack of thinking about risk to reputation leads to a lack of common sense, and in the end, failure.
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